ARR – Accounting Rate of Return

What Is The Accounting Rate of Return (ARR)?

The Accounting Rate of Return (ARR) is a corporate finance statistic that can be used to calculate the expected percentage rate of return on a capital asset based on its initial investment cost.

ARR helps businesses decide which assets to invest in for long-term growth by comparing them with the return of the other assets. 

Accounting Rate Of Return is also known as the simple rate of return because it doesn't take into account the concept of the time value of money, which states that the present value of money is worth more now than in the future.

ARR comes in handy when the investment needs to be evaluated based on the profits rather than the cash flow it expects to generate in the future.

This is one of the simplest methods to calculate the return on any investment, so sometimes, it acts as a tool for the short-term investor to segregate various investment opportunities and focus on those who remain within the required rate of return of the investor.

The formula for calculating the Accounting Rate of Return is:

ARR = Average Annual Profit from the investment / Initial Investment *

Instead of initial investment, we can also take average investments, but the final answer may vary depending on that.

Steps for calculating Accounting Rate of Return

To calculate the Accounting Rate of Return (ARR), we need to follow the below steps:

1. Calculate the total net profit from the investment, which includes revenue generated by the asset, excluding all the necessary expenses incurred, such as operating expenses, interest, taxes, etc. 
2. After calculating the total net profit arising from the asset, divide it by its estimated working life to arrive at the average annual profit from the investment. If the investment is in the fixed asset, then work out the depreciation aspect to be deducted at the end while calculating the net annual profit of the asset. 
3. Finally, divide the Average Net annual Profit from the investment by the initial investment to arrive at the Accounting Rate of Return.

Examples for calculation of Accounting Rate of Return

Let us go through some of the examples for calculating ARR.

Example #1

A company decided to purchase a fixed asset costing $25,000.This fixed asset would help the company increase its revenue by $10,000, and it would incur around $1,000. 

The useful life of the fixed asset is 20 years. What would be the Accounting Rate of Return for the year?

Since it is about the fixed asset, we need to take into account the amount of depreciation to calculate the annual net profit of the required investment. 

So, 

The Initial Investment = $25,000

Annual Profit Generated = $10,000

Annual Expenses = $1,000

 

Annual Depreciation = $25,000 / 20 = $1,250

Annual Net profit from the Investment = $10,000 - $1,000 - $ 1,250 = $ 7,750

 

Accounting rate of Return = $7,750 /$25,000 = 31 %

This 31% means that the company will receive around 31 cents for every dollar it invests in that fixed asset.

Example #2

ABC Company is considering investing in a country to expand its business. For that, they require an investment of around $250,000. 

The total Cash Inflow from the investment would be around $50,000 in the 1st Year, $45,000 for the next three years, and $30,000 for the 5th year. In the end, the investment will have a salvage value of around $50,000.

So, the first step would be to calculate the average annual profit. 

Cash flow in the 1st year = $50,000

Total Cash flow in the 2nd, 3rd ,and the 4th year = $ 45,000*3 = $ 150,000

Cash flow in the 5th year = $30,000

Total Cash In flow = $50,000 + $150,000 + $ 30,000 = $230,000

 

Total Depreciation = ($250,000 - $ 50,000) = $ 200,000

Total Profit = ($230,000 $ 200,000) = $ 30,000

Average Net Total Profit = $30,000 / 5 = $6,000

Average Initial Investment = ($250,000 + $50,000 / 2 = $150,000

 

Accounting rate of return = $6,000 / $ 150,000 = 4%

In this example, there is a 4% ARR, meaning the company will receive around 4 cents for every dollar it invests in that fixed asset.

Calculation of ARR in excel 

It is crucial to record the return on your investment using programs like Microsoft Excel or Google Sheets to keep track of it. If you are using excel as a tool to calculate ARR, here are some of the most important steps that you can take.

1. Firstly mention the year in the first cell of excel, and then corresponding to that, mention the number of years you want the project to give the returns. In the above example, we have assumed five years. 

2. Write down the initial investment amount in the second row here. It is 1,00,000, which acts as the major cash outflow for the project.

3. Mention salvage value, if any, in the table (here, we have assumed it to be around 20,000).

4. Now mention ARR in the last cell and put a formula in the cell with an average of all the net income values mentioned in a row divided by the average of initial investment, which is 1,00,000 and 20,000, arrive at the percentage figure of ARR. In the above example, it is 33.3% which means for every dollar the company invests, and it will receive around 0.33 cents in return.

Advantages and disadvantages of ARR

There are various advantages and disadvantages of using ARR when evaluating investment decisions.

Some of the advantages are:

• It is one of the simplest methods to calculate the profitability of a project. 

• It is easy to calculate and understand the payback pattern of the required investment.

• It is useful compared with other companies and helps us know which company is performing well against the others. 

• Short-term investors use this method more frequently for assessing their investment decisions.

• It helps in evaluating the current performance of an investment.

• It displays the investment's cumulative book profit so that it can be contrasted with the results of other initiatives. 

• Useful for demonstrating how well a project performs over time.

• It can be used to determine the projects a firm should invest in and those that it shouldn't.

• It can help in determining how well the project does in terms of profits rather than cash flows. 

The Disadvantages of A.R.R are:

• One of the main disadvantages of this method is that it ignores the time value of money, which is the most important concept for determining the overall investment opportunity.

• This method of calculating profit cannot be used when the investment is being made on an installment basis rather than lump-sum. 

• This method ignores the factors that are external to the business environment of the company, which affects the investment decision of the firm.

• While calculating the return from the R.O.I. method, the answer will be different from that of the A.R.R. R.O.I. method is the most suitable method for calculating the project's return when the investment is long-term in nature; hence A.R.R. is not suitable when the investment is for long term nature.

• This method is based only on accounting profits and does not make adjustments such as cash flows, taxes, etc. 

• This project does not consider the period of the various investment; hence it may not produce accurate and desired results when comparing it with the other investments.

• Because the Accounting Rate of Return is a metric that represents the total investment and can be distorted by changes in the beginning book value, smaller businesses may not have a strong A.R.R.

• Don't factor in potential savings or future expenditures associated with investments.

• Regarding the initial financial outlay, this method does not account for dividends or any other sources of funding.

• Accounting rates of return may be skewed if only cash in and cash out are considered, rather than how much it will cost to replace assets when they wear out.

ARR vs. IRR

In investment evaluation, the Accounting Rate of Return (ARR) and Internal Rate of Return (IRR) serve as important metrics, offering unique perspectives on a project's profitability.

ARR estimates the anticipated profit from an investment by calculating the average annual profit relative to the initial investment. However, it simplifies calculations by neglecting the time value of money.

On the other hand, IRR provides a refined analysis, factoring in cash flow timing and magnitude. It represents the yield percentage a project is expected to deliver over its useful life.

Unlike ARR, IRR employs complex algebraic formulas, considering the time value of money by discounting all cash flows to their present value. This detailed approach, giving more weightage to current cash flows, enables IRR to assess investment opportunities comprehensively.

To summarize, check the table below:

RRR vs. ARR

ARR is the annual percentage of profit or returns received from the initial investment, whereas RRR is the required rate of return that the investor wants. RRR is also known as the hurdle rate. 

RRR can be calculated using the dividend discount model or CAPM (Capital Asset Pricing Model).

ARR is constant, but RRR varies across investors because each investor has a different variance in risk-taking. 

For example, if a project has an ARR of 20% and an investor thinks that the company would outgrow itself, then he would settle for a less expected return in the short run, but the investor who takes calculated risk then would demand a high percentage of return for his investment. 

Difference between ARR and Profitability Index 

Researched and authored by Ashish Sharma I LinkedIn

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